Family trust tax ‘trap’ lurks beneath the surface
Advisers should take caution on client family trusts with reimbursement agreements that can be taxed on an entitlement at the maximum personal tax rate, but beware of being caught out by a big yet avoidable “trap”, according to SuperConcepts.
In a recent blog post, SuperConcepts technical manager for SMSF technical and private wealth Graeme Colley said the ATO is currently in the process of issuing a draft ruling on clarifying what constitutes a reimbursement arrangement.
What defines a reimbursement arrangement?
Mr Colley said a reimbursement agreement is treated as being in place where a trust distribution is made to a beneficiary who is tax-exempt or taxed at preferential tax rates, but another person gains the ultimate benefit from the distribution.
He said examples of beneficiaries include companies or others who have carry-forward losses and end up paying a lower rate of tax than the maximum personal rate.
“A self-managed superannuation fund is unlikely to fall into the acceptable beneficiary category as distributions from family trust arrangements are taxed as non-arm’s length income at 45 per cent,” Mr Colley said.
“An example of a reimbursement agreement would include a trustee of a discretionary trust makes a distribution to a beneficiary, such as an individual or entity, that is presently entitled to income and is liable to pay tax at less than the maximum personal rate of 45 per cent.
“However, rather than making the payment of the distribution to the beneficiary, the trustee gifts or lends the distribution interest free to another person, but they are not subject to tax on the amount received. Overall, less tax is paid on the trust distribution.”
According to Mr Colley, the law does allow some distributions paid to beneficiaries that would normally qualify as reimbursement agreements to be taxed in the beneficiary’s hands rather than the trustee.
He said these are referred to as ordinary family or commercial dealings and would include a will trust where the beneficiary is a minor, unpaid trust distributions which are converted to a loan under Division 7A of the tax law, and where the arrangement is not considered to be part of a tax avoidance arrangement.
Further, Mr Colley noted that, as with all tax law, whether the distribution is taxed in the hands of the trustee or the beneficiary depends on the circumstances of the case, with the key questions to be answered being:
- whether an arrangement exists for another person or entity to benefit from the distribution other than the original beneficiary who was presently entitled, and
- if there is an arrangement in place, whether it is in the nature of an ordinary commercial or family dealing.
The potential ATO ‘trap’
However, Mr Colley said the big trap in all of this is the power of the ATO to go back as far as it wants to tax the trustee if they consider a reimbursement agreement exists.
“Whether records exist in some of these cases is doubtful. This compares to normal taxpayers who are required to keep records for five years from the time their income tax return is lodged,” he said.
“I’m sure advisers and anyone who has family trust arrangements where distributions are made to beneficiaries on lower than the maximum rate will be interested to see what the ATO has to say on reimbursement agreements whenever the draft ruling hits the streets.”
Adrian Flores is the deputy editor of SMSF Adviser. Before that, he was the features editor for ifa (Independent Financial Adviser), InvestorDaily, Risk Adviser, Fintech Business and Adviser Innovation.